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Crowdfunding: A Non-traditional Source of Business Financing

Brett Stuckey and Adriane YongEconomics, Resources and International Affairs Division

According to the Industry Canada report Credit Condition Trends, in 2013, financing approval rates were 81% for businesses with up to four employees, 84% for those with between five and 19 employees, and 93% for those with between 20 and 99 employees. With unmet financing needs, some of Canada’s small businesses are turning to non‑traditional sources, such as crowdfunding.

Crowdfunding involves fundraising through small contributions from many parties, and usually results from an “open call” on social networking sites. While crowdfunding may be better known for its financing of “projects,” such as raising funds for disaster relief and creative endeavours, it is increasingly used by businesses in their “start-up” or development phases.

According to Crowdsourcing LLC’s Directory of Sites, on 26 November 2014, there were 523 active crowdfunding online platforms around the world, 12 of which were in Canada. In 2013, global crowdfunding activities had an estimated value of between US$3 billion and US$5 billion.

However, crowdfunding in Canada may be limited by the current regulatory environment. Perhaps for that reason, the federal government and provincial securities regulators have started to address taxation and securities regulation in the context of crowdfunding.

Three models: Donation, lending and investment

There are three crowdfunding models – donation-based, lending-based and investment-based – and they usually have three participants:

the creator of a project or business, who is looking for financial or non-financial contributions;

the donors or investors, who would like to contribute to the project or business; and

the online platform, which links the creator and the donors or investors.

Donation-based models, which are the most common, annually raise the most money through online platforms around the world. They are generally used for philanthropic or social engagement purposes. While donors may receive gifts or other acknowledgements to recognize their contributions, they do not receive any rights or equity in the project or business.

With lending-based models, which are second in popularity, investors lend money to the creator with the expectation of repayment. These models include:

a traditional lending agreement, in which the loan plus interest is repaid in a lump sum or according to a payment schedule;

a forgivable loan, in which repayment occurs when the project generates revenue or makes a profit; or

pre-sale, in which a finished product is provided in return for the contribution.

With investment-based models, which are of two types, investors receive equity in the creator’s project or business. The profit-sharing model gives investors a share of the revenue or profit, while the securities investment model gives investors ownership and/or voting rights through their purchase of securities.

Easing prospectus requirements

Canadian securities laws require a prospectus to be prepared before investments are offered for sale to the public. As crowdfunding generally occurs at the “start-up” or development phase of a project or business, limited funds may be available to prepare such a document.

Recently, some Canadian securities regulators have either reduced – or have proposed to reduce – the prospectus requirements for small businesses and/or crowdfunding activities. For example, in December 2013, Saskatchewan’s securities regulator implemented an exemption that allows small businesses that have not previously issued securities to the public to engage in securities investment crowdfunding without having to prepare a prospectus.

According to Saskatchewan’s exemption, the creator can make two six-month offerings of $150,000 each over a 12-month period. An investor, who is limited to $1,500 per offering, must be able to access – on the online platform – details about the anticipated uses for the funds and the investment’s potential risks.

The securities regulators in Manitoba, New Brunswick, Nova Scotia, Quebec and Saskatchewan requested public comments on both types of exemptions by 18 June 2014. The securities regulators in Alberta, Prince Edward Island and Newfoundland and Labrador do not appear to have addressed the crowdfunding issue.

The proposed start-up exemption would allow small businesses that have not yet sold securities to the public to sell securities through an online platform without having to prepare a prospectus, although the investment would have to be described on the platform.

The proposed crowdfunding exemption, which could be finalized in some provinces by the end of 2014, would allow Canadian businesses to raise funds through online platforms.

For example, in Ontario, a creator would be permitted to raise up to $1.5 million during a 12-month period. An investor would be limited to $2,500 in a single offering or $10,000 in a calendar year. Moreover, the creator would be required to provide – on the online platform – prescribed financial information and perhaps audited financial statements, and would have ongoing disclosure requirements. An investor would have to sign a risk acknowledgement form prior to purchasing the securities.

Addressing crowdfunding tax issues

In an August 2013 letter, the Canada Revenue Agency provided guidance about the taxation of funds collected through a donation-based crowdfunding model.

The funds received by the creator are considered to be business income. Expenses relating to crowdfunding efforts – such as the cost of gifts for donors and any relevant fees – could be deductible from this income.